Encyclopedia of Business, 2nd ed.

OPPORTUNITY COST

Photo by: Ben Chams

An opportunity cost is defined as the value of a forgone activity or
alternative when another item or activity is chosen. Opportunity cost
comes into play in any decision that involves a tradeoff between two or
more options. It is expressed as the relative cost of one alternative in
terms of the next-best alternative. Opportunity cost is an important
economic concept that finds application in a wide range of business
decisions.

Opportunity costs are often overlooked in decision making. For example, to
define the costs of a college education, a student would probably include
such costs as tuition, housing, and books. These expenses are examples of
accounting or monetary costs of college, but they by no means provide an
all-inclusive list of costs. There are many opportunity costs that have
been ignored: (1) wages that could have been earned during the time spent
attending class, (2) the value of four years' job experience given
up to go to school, (3) the value of any activities missed in order to
allocate time to studying, and (4) the value of items that could have
purchased with tuition money or the interest the money could have earned
over four years.

These opportunity costs may have significant value even though they may
not have a specific monetary value. The decision maker must often
subjectively estimate Opportunity costs. If all options were purely
financial, the value of all costs would be concrete, such as in the
example of a mutual fund investment. If a person invests $10,000 in Mutual
Fund ABC for one year, then he forgoes the returns that could have been
made on that same $10,000 if it was placed in stock XYZ. If returns were
expected to be 17 percent on the stock, then the investor has an
opportunity cost of $1,700. The mutual fund may only expect returns of 10
percent ($1,000), so the difference between the two is $700.

This seems easy to evaluate, but what is actually the opportunity cost of
placing the money into stock XYZ? The opportunity cost may also include
the peace of mind for the investor having his money invested in a
professionally managed fund or the sleep lost after watching his stock
fall 15 percent in the first market correction while the mutual
fund's losses were minimal. The values of these aspects of
opportunity cost are not so easy to quantify. It should also be noted that
an alternative is only an opportunity cost if it is a realistic option at
that time. If it is not a feasible option, it is not an opportunity cost.

Opportunity-cost evaluation has many practical business applications,
because opportunity costs will exist as long as resource scarcity exists.
The value of the next-best alternative should be considered when choosing
among production possibilities, calculating the cost of capital, analyzing
comparative advantages, and even choosing which product to buy or how to
spend time. According to Kroll, there are numerous real-world lessons
about opportunity costs that managers should learn:

Even though they do not appear on a balance sheet or income statement,
opportunity costs
are real. By choosing between two courses of action, you assume the
cost of the option not taken.

Because opportunity costs frequently relate to future events, they are
often difficult to quantify.

Most people will overlook opportunity costs.

Because most finance managers operate on a set budget with predetermined
targets, many businesses easily pass over opportunities for growth. Most
financial decisions are made without the consultation of operational
managers. As a result, operational managers are often convinced by finance
departments to avoid pursuing value-maximizing opportunities, assuming
that the budget simply will not allow it. Instead, workers slave to
achieve target production goals and avoid any changes that might hurt
their short-term performance, for which they may be continually evaluated.

People incur opportunity costs with every decision that is made. When you
decided to read this article, you gave up all other uses of this time. You
may have given up a few minutes of your favorite television program or a
phone call to a friend, or you may have even forgone the opportunity to
invest or earn money. All possible costs should be considered when making
financial or economic decisions, not simply those that can be concretely
measured in terms of dollars or rates of return.